Those who are sufficiently steeped in the old point of view simply cannot bring themselves to believe that I am asking them to step into a new pair of trousers, and will insist on regarding it as nothing but an embroidered version of the old pair which they have been wearing for years (John Maynard Keynes, "The Pure Theory of Money: A Reply to Dr. Hayek," Economica 11 [November 1931]:390).

3.7.2

The major macroeconomic problem facing Western economies today is that of explaining why the supposedly mild inflations of the two decades following World War II turned into the intractable "stagflation" besetting theorist and policymaker alike. The two major analytical approaches to the problem, that of the Keynesians and that of the monetarists, have a serious failing in common: they ignore the real side of the economy and hence the real maladjustments brought about by a monetary policy that interferes with the coordination of economic activities. Both views implicitly assume that the real side of the economy is always in some sort of long-term equilibrium, in which money influences only the price level or money income and not the structure of relative prices or the composition of real output. As we intend to show, such a point of view belongs to a stage in the history of economic thought before the structure of output and the influence of prices on production had been worked out.

3.7.3

We shall also offer an exposition of an alternative analysis derived from the Austrian school of economic thought, especially from the writings of Friedrich A. Hayek. In so doing, we shall indicate how a Hayekian analysis of the effects of monetary changes on the structure of prices and outputs enables us to delve beneath the monetary surface to the real underlying phenomena and thereby call attention to the misallocation resulting from a monetary system that discoordinates economic activity.

3.7.4

Not all possible alternatives to the Austrian view will be covered. For instance, we shall not examine the extensive neo-Ricardian critiques of the current orthodoxy advanced by Joan Robinson, Nicholas Kaldor, and Piero Sraffa, since we regard these criticisms as part of a more general attack on subjectivist marginalist economics. Nor shall we consider in detail the work of Robert W. Clower and Axel Leijonhufvud, which in part complements our own work here.*70 We would argue, however, that virtually all writers and all non-Austrian schools of thought have ignored the importance of Hayek's work in explaining important features of the business cycle.

I

3.7.5

World War II marked a great shift in the character of the macroeconomic problems developed countries had to face. In the years after World War I, policymakers had to cope with a "typical" economic crisis, which was followed by what in the 1920s had been taken to be a stable expansion and then by a second crisis, only this time one of unprecedented intensity and length. However, after 1945, the problem turned around completely and became that of gently (and later, more rapidly) rising prices. In eleven major developed countries, prices declined hardly at all, and when they did, it was only for a couple of years during the early fifties.*71 Price indices remained stable for some years in several of these countries, but these periods of relative price stability were outnumbered by years of rising prices, so that in effect prices have been rising more or less steadily ever since the end of World War II.

3.7.6

Generally output rose pari passu with prices. Indeed, the countries of the European Economic Community, together with the outstanding examples of Israel and Japan, were generally extolled for their economic growth record in comparison with such "slow growers" as the United Kingdom.*72

3.7.7

However, two ominous symptoms of underlying structural distortions then appeared: annual rates of price increases sharply accelerated, running in most developed countries well into two-digit figures, and rates of increase in output began to slacken. Unemployment percentages, at historic lows since the late forties, started an upward climb, and every attempt to reduce the rate of price increase brought fresh upward jumps in unemployment and excess industrial capacity. Forecasts of the Organization for Economic Cooperation and Development described the price situation as "worrying" and reported that, although price inflation continued at historically high rates (in excess of 12 percent per annum in early 1974), growth continued to decelerate (that is, aggregate demand fell in relation to aggregate supply). "Over the last few years unemployment seems to have risen in relation to demand pressures," and the "unemployment rate at the peak of the boom is higher than at earlier peaks."*73

3.7.8

This stagflation dilemma seemed far more serious in the United Kingdom than elsewhere. Retail prices rose every year after 1945, yet growth rates in output remained low compared to the European Economic Community. Periodic attempts to bolster the rate of growth regularly ran into balance-of-payments problems leading to the well-known "stop-go" cycle. Here, too, the interval between "go" and "stop" steadily decreased. For example, in 1974 the chancellor of the exchequer chose to introduce "reflationary" preelection measures hardly two months after a "deflationary" postelection budget.

3.7.9

In the United Kingdom more than in any other developed country, acceleration in the rate of price increase was combined not merely with a low rate of growth in output but with a zero or even a negative growth rate. The rate of increase in the retail price index exceeded 10 percent well before it did in any other developed country, and even before this happened, the retail price index began climbing well ahead of output. In late 1974 the price increase showed every sign of continuing into the 20 percent range, while output continued to slacken. For the United Kingdom an inflationary depression in the eighties seemed quite likely.*74 While inflation in the United States was not so serious as that in the United Kingdom, there was every indication that the United States was but a few years behind the United Kingdom in this respect. Unemployment rates were higher in the United States than in the United Kingdom. And some would argue that the United States was already experiencing the inflationary depression feared for the United Kingdom.

3.7.10

What went wrong? Why did the gently rising price level of the fifties and the sixties give way to two-digit increases, which hardly anyone expected? Why did unemployment rear its head with every slackening of the rate of price increase?

THE KEYNESIAN DIAGNOSIS

3.7.11

Many Keynesians view the post-1945 situation as one of "cost inflation," that is, of rising cost levels pushing up the price level, with a passive monetary system furnishing the necessary finance.*75 Costs, the active variable, determine prices, while the money supply adapts passively.*76 Attempts to control the supply of money, rather than to control costs directly, must create unemployment without reducing prices, since costs continue to rise. However, if costs can be controlled directly, for example, by some kind of incomes policy, it would be possible to achieve both full employment and a stable price level.*77 And the thirties are viewed as a warning (not only by the Keynesians but others as well), as an example of what happens when money income and expenditure are not expanded sufficiently to restore full employment.*78

3.7.12

This view epitomizes the policy teachings of modern macroeconomics. The modern treatment of interest rates is a good example of the way Keynesian analysis neglects the microeconomic significance of the structure of relative prices and outputs that actually characterizes the real world. The interest rate—or market spectrum of interest rates—is the closest approach in macroeconomics to anything like a price. Of course, in the one-or-two-commodity worlds usually treated in macromodels, changes in interest rates have—by hypothesis—no micro implications.*79 But even here the Keynesian approach offers no long-run theory of interest rates or even bothers to discuss in detail the real factors affecting the money rate of interest.*80 What we have instead is an analysis of the impact on interest rates of changes in the rate at which the money stream enters the money market. This may give us a hypothesis for explaining short-run changes in market interest rates, but it is not itself a theory of interest. As D. H. Robertson pointed out, in his classic characterization of Keynes's liquidity-preference theory:

Thus the rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has been amputated. And yet it somehow still exists—a grin without a cat.*81

3.7.13

In the Keynesian macro approach prices remain completely rigid in both absolute and relative terms. Changes in the structure of relative prices are ignored as analysis often explicitly assumes that prices remain always "at their historic levels."*82

3.7.14

In a similar manner, the structural composition of output is also considered irrelevant; indeed, the Keynesian concept may be said to be that of full unemployment, that is, the implicit assumption that all goods and services are available in abundance, so that output and employment can be increased by all firms simultaneously. Or, to put this point somewhat differently, the level of unemployment and excess capacity at the bottom of the cycle is assumed to be uniform throughout the economy. The substantial variations, in both unemployment and excess capacity, as among different firms, industries, and regions, are disregarded in the Keynesian framework as having little analytical significance.

3.7.15

In such a scheme, then, the level of output and employment depends on the level of monetary expenditure or, in more sophisticated variants, the rate of increase of monetary expenditure. The supply side is implicitly ignored, and, as just mentioned, the concentration on levels of utilization (of labor and other factors) implies that on the real side there is a constant equilibrium being maintained in the structure of output.

3.7.16

It might also be pointed out that for the Keynesian, an inflationary recession (that is, a rising price level and a rising unemployment rate) is a particularly difficult problem with which to deal. Inflation should only result when aggregate demand continues to rise as full employment is reached.

At the other extreme (or so it seems) we have Milton Friedman and the monetarist school of thought. Yet Friedman also interprets the historical experience of the twenties and the thirties in purely monetary terms. For him also, as we shall see, there is no real problem of coordination to worry about at the macroeconomic level.

3.7.18

The monetarist approach may be represented by a quotation from John S. Mill:

In considering value, we were only concerned with causes which acted upon particular commodities apart from the rest. Causes which affect all commodities alike do not act upon values. But in considering the relation between goods and money, it is with the causes that operate upon all goods whatever that we are especially concerned. We are comparing goods of all sorts on one side, with money on the other side, as things to be exchanged against each other.*84

3.7.19

For Mill, as for many of the classical economists, changes in the money supply affect aggregate spending but not relative prices. Pricing—the determination of value—is not affected by monetary disturbances. For the most part, Mill analyzed changes in the quantity of money in terms of what the modern economist would describe as a discrepancy between actual and desired cash balances. The real side of production is assumed to be largely unaffected.*85

3.7.20

Monetarism has hardly advanced beyond the classical position; accordingly, it is not surprising that the classical economists can sound quite modern. In his analysis of some specific problems in microeconomics, Friedman adopted what is basically the outlook of methodological individualism. But in his monetary theory (and in that of others of the same school) we find, quite inconsistently, an aggregative analysis, utilizing holistic macroconstructs that are treated (wrongly) as if they interacted directly with one another. This procedure entirely ignores the microeconomic pricing process, which actually determines the real structure of prices and output.*86 Monetarism then does not differ in its fundamental approach from the other dominant branch of orthodox economics, that of Keynesianism. A microtheorist is distinguished by his adherence to the principle of methodological individualism when answering all questions; that is, he analyzes economic problems in terms of the effects of a given change on the expected costs and benefits facing transactors. A microeconomist is thus led to analyze (among other things) the market process and its complex interrelationships. In this respect, at least, Friedman is not a consistent methodological individualist.

3.7.21

Friedman argued that real factors determine real magnitudes. Real forces thus determine real income, while monetary forces determine nominal income, with the price level as the joint outcome of the two forces. (Such an approach differs little from the older views of Irving Fisher and is open to all the criticisms leveled against that approach.)*87 To the foregoing, Friedman appended a short-run adjustment process "in which the rate of adjustment in a variable is a function of the discrepancy between the measured and the anticipated value of the variable or its rate of change, as well, perhaps, as of other variables or their rates of change."*88

3.7.22

Friedman hypothesized such an adjustment process because for him the key question of monetary theory is the reaction to a discrepancy between the nominal quantity of money supplied and the nominal quantity demanded. Monetary expansion, then, affects only the price level; there are no structural maladjustments, while depressions, on the other hand, are largely, if not entirely, the outcome of a decline in the rate of growth of the stock of money. True, in the transition from a rising to a stable price level, there may be some unavoidable transitional decline in output and employment, as money prices adjust themselves to the reduced rate of increase in the stock of money. But provided this reduction is gradual, there need not be any significant impact on employment and certainly not a fall in aggregate output. A monetary expansion, on the other hand, simply reverses this process: initially, as the money supply expands and prices rise, wages (and other costs) fail to rise (because the information has not yet spread throughout the economy), and mostly profits increase. Hence output and employment expand—temporarily. Once nominal wages and other costs are bid up in line with the new price level, profits shrink to their "normal" level, as determined by the real elements of the situation. There arc-no prolonged misallocations anywhere. The pattern of output is untouched. If we wish to push unemployment below its "natural" level and expand the money supply to this end, larger and larger increases will become necessary, as the system adjusts to the rises in money prices. But a serious recession or depression need not result, since monetary expansion creates no real distortions, and the banking system is now geared to prevent any serious deflations in the stock of money.*89 Consistent with these views, Friedman attached no real significance to the monetary expansion of the twenties inasmuch as the price level remained fairly stable, while in the early thirties the substantial decline in output and employment in United States was due directly to the substantial contraction in the stock of money during the years 1929-32 but not to what had preceded it.

3.7.23

The monetarist position may be restated as follows: in real terms, prices are always tending to their long-term equilibrium level; monetary changes affect only their nominal height and have no lasting impact on production. Because Friedman viewed underlying economic reality as being adequately described by long-run Walrasian equations, such a position is the only reasonable one—since long-run equilibrium by definition excludes any real disequilibrium! Nor could Friedman consistently superimpose imperfect anticipations onto a system in which all expectations are by definition consistent and realized. Finally, in the ad hoc "adjustment process" Friedman postulated, he failed to distinguish between price changes that coordinate production and those that do the opposite! In other words, he assumed that price changes represent movements from one equilibrium to another. But the proposition under question is precisely whether price changes can be assumed to automatically coordinate: the Hayekian analysis, as will be shown, demonstrates that under certain monetary conditions some price changes may seriously discoordinate production. In short, in the terminology originally introduced by Hayek, money is not always "neutral." In any case, general equilibrium equations, being solely definitional, leave out of consideration the whole market process—indeed, such equations can tell us nothing about this intertemporal process.*90 But it is precisely these interrelated price changes that guide production over time and therefore cannot be overlooked.

3.7.24

The aggregative macro constructs, on which Friedman and the monetarists base their analyses, are in the end similar to other orthodox schools of thought (including the Keynesians, as Friedman readily acknowledges).*91 In relying on these constructs the monetarists appear to be unaware of the real effects of money on the economic system—money's effect on individual prices and price interrelationships and hence on the whole structure of outputs and employments. By ignoring the structure of production and the influences of prices on production, the monetarist analysis shares a common deficiency, not only with the Keynesians, but indeed with the entire analytic framework of the current orthodoxy. The monetarists no less than the Keynesians lay themselves open to Hayek's criticism that such thinking takes "us back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest."*92

II

3.7.25

As we have seen, the principal deficiency of both the Keynesian and the monetarist approach is the neglect of the microeconomics of business cycles. Furthermore, it is doubtful whether even the existence of money can be adequately accounted for in a Walrasian framework.*93 In any case, Keynesians and monetarists alike fail to find any place for money in the pricing process: money is given no role in determining relative prices.

3.7.26

The Austrian contribution to monetary theory is two-fold: First, it emphasizes the role of money in the pricing process and incorporates money—or, more precisely, changes in the stream of money payments—into the determination of relative prices. Second, it analyzes the effects of such money-induced relative price changes on the time structure of production, that is, the capital structure.

3.7.27

Carl Menger provided the theoretical framework for explaining why a medium of exchange was used.*94 Then, after Knut Wicksell drew attention to the failure of the classical quantity theory to explain how changes in the money supply affect prices,*95 Mises, building on Menger and Wicksell, showed more completely how money could be integrated into general economic theory. He went on to outline a theory of cyclical fluctuations in which monetary disturbances lead to misallocations.*96 Hayek built on the theories of Menger, Böhm-Bawerk, Wicksell, and Mises to amplify and expand the Austrian monetary tradition, especially in capital and business cycle theory.*97 The analysis that follows builds on this tradition.

MONETARY EXPANSION, PRICING, AND RESOURCE ALLOCATION

3.7.28

Monetary changes are not neutral—they do not affect all prices uniformly so as to change their nominal height but leave relative price relationships unaltered. In reality money does not enter the economy by way of a simple uniform change in all money balances, as many textbook writers like to assume. Rather, newly created money always enters the economy at a specific point and is spent on certain specific goods before gradually working through the system.

3.7.29

Thus some prices and expenditures are altered first, and other prices and expenditures, later. As long as the original monetary change is maintained, this monetary "pull" on price interrelationships will persist. This point is fundamental to the analysis that follows.

3.7.30

Hayek likened the effects of money on pricing to the process of pouring a viscous liquid (honey in his example) into a vessel:

There will, of course, be a tendency for it to spread to an even surface. But if the stream (of honey) hits the surface at one point, a little mound will form there from which the additional matter will slowly spread outward. Even after we have stopped pouring in more, it will take some time until the even surface will be fully restored. It will, of course, not reach the height which the top of the mound had reached when the inflow had stopped. But as long as we pour at a constant rate, the mound will preserve its height relative to the surrounding pool.*98

3.7.31

Resource allocation will not be left unchanged as a result of these relative price changes. At the point at which the new money enters the economy, prices will rise relative to prices elsewhere. The pattern of outputs will be altered correspondingly. Monetary expansion also prevents some prices from falling that otherwise might. Thus some businesses make profits that otherwise would have losses, and workers are employed in jobs they otherwise would leave. Another result of the monetary expansion is that more new and different kinds of businesses are started. Firms are also led to embark on new and/or different lines of production. In short, the pattern of expenditures, resource allocation, and above all relative prices is changed by monetary expansion.

3.7.32

Typically an expansion of the money supply takes the form of an increase in bank credit. (While governments can simply print extra currency, they usually prefer less obvious methods of reaching this objective and thereby bridging the chronic gap between fiscal incomes and expenditures.) Let us consider the impact of an increase in the rate of growth of bank credit. Bank-credit expansion at first reduces interest rates below the level they otherwise would attain. The overall pattern of expenditures is necessarily altered: investment expenditures rise relative to current consumption expenditures and to savings, the increase being measured approximately by the increase in the money supply.

3.7.33

Monetary expansion thus leads to a discoordination between the saving and investment plans of the nongovernmental public. The Keynesian and the monetarist would find little to quarrel with in the analysis up to this point: the former would agree that if planned investment exceeds planned savings, incomes and output and possibly prices will rise; the latter would say that an increase in the stock of money will raise incomes and prices and perhaps output. The Austrian analysis, however, goes farther—to detail the changes in the pattern of expenditures and hence in the pattern of outputs, resulting from the consequent changes in relative prices.

MONETARY EXPANSION AND THE PRODUCTION STRUCTURE

3.7.34

As we have just seen, in crudely aggregative terms, monetary expansion leads initially to a drop in interest rates relative to what they would have been and a rise in investment expenditures relative to consumption expenditures, that is, a decline in the uniform rate of discount will raise the demand-price schedule for durable capital goods—and even more so, for the more durable goods—in relation to the demand-price schedule for current consumption services. But this is only the beginning.

3.7.35

There has not been a change in the supply of capital goods. Capital is not a homogeneous stock but an interconnected structure of interrelated capital goods. By disrupting price signals, the effect of monetary expansion is to throw this structure out of coordination.

3.7.36

In the Hayekian view, production is seen as a series of "stages," beginning with final consumption and extending through to stages systematically and successively farther removed from this final stage.*99 Factor services are applied to the unfinished products moving through these stages. In other words, production consists of a series of interrelated processes in which heterogeneous capital goods are grouped in specific combinations, together with land and labor services.

3.7.37

Capital goods usually and land and labor to some extent are specific to particular stages of production. Capital goods are thus in general not homogeneous and substitutable; they are heterogeneous and complementary and usable only in specific combinations: for example, a machine from a shoe factory cannot be combined at random with a machine from an automobile plant to produce some third product.*100 Generally, if capital investments (such as shoe factories and automobile plants) are to add more to final output than any other capital combination, they must fit into an integrated production structure completed to the final consumption stage, that is, they must fit into an interlinked series of complementary investments.*101

3.7.38

The increased bank credit flowing into the system at temporarily depressed interest rates alters the relative profitability of capital invested in different stages; the streams of quasi-rents accruing to the various capital goods are changed; and these goods are rearranged into different capital combinations. At the lower interest rates, certain formerly unprofitable investments become profitable. Additional bank credit does not produce additional labor and land services; hence the new investments must necessarily use relatively less labor. Because more money is available and interest rates are lower, factor rental prices are bid up relative to product prices, that is, real factor costs increase.*102 Hence entrepreneurs try to adopt less labor-intensive (that is, more "capitalistic") production methods. Demand for raw materials increases also.

3.7.39

Conversely, certain formerly profitable investments now become unprofitable: returns decline on capital goods that are usable only in relatively more labor-intensive methods and that cannot readily be adapted to the use of less labor. Demand for the different sorts of capital goods depends on relative factor costs and on the expected returns from using the machines to produce other products. Firms producing capital goods geared to unprofitable capital combinations find that they face increased factor costs while demand for their machines is falling off. Hence these firms (or lines of production) contract, while other firms producing goods adapted to the newer, more profitable capital combinations find demand rising and increase their output.

3.7.40

Changing price signals reduce profits on production for current consumption and increase profits on production for future consumption, thus altering rates of return on the different capital combinations involved.*103 Returns decline in production stages nearer to consumption, while returns increase in stages farthest from final consumption. Nonspecific resources are thus shifted from the former to the latter: output of consumer goods declines, while the pattern of production of capital goods is so altered as to produce goods that fit into a production structure extending through more stages than was previously possible.

3.7.41

In order that these investments may all be completed down to the final consumption stage, it is necessary that the requisite resources continue to be released from consumption, that is, that a decline in consumption output be maintained until, the new production structure is completed. It must be remembered that, because of intertemporal complementarily, a machine whose usefulness depends on the construction of additional capital goods will be economically useless if the-requisite resources are diverted elsewhere (that is, to the production of consumption output in this case). In order to complete all the capital combinations appropriate to an extended production structure, capital goods are now required that, given the intensity of consumption demand, are not available.

THE SELF-REVERSIBILITY OF MONETARY CHANGES

3.7.42

Consumption demand begins to increase as a result of the increased money incomes that factor owners have been receiving as a consequence of the increase in bank money. By hypothesis there has been no change in the rate of saving out of income. As these incomes are spent, the increased consumption expenditure meets an attenuated supply of consumer goods. Prices of consumer goods now, at this later stage, begin to rise relative to the prices of unfinished products, especially those farthest away from the final consumption stage. The process described earlier is now reversed: returns rise in stages nearer consumption, while returns decline in stages farthest from consumption. Nonspecific resources are once more drawn back into the production of consumer goods. All those capital goods intended for a different production structure have now to be readapted, to fit another, less capitalistic structure, with concomitant losses and unemployment. These losses are particularly heavy on those capital goods most suited only to a more capitalistic structure. Capital goods that are profitable to produce only at the lower rates of interest have been overproduced. They have been overproduced because the price signals generated by the hypothesized monetary policy have resulted in the production of inappropriate combinations of capital goods. Capital goods appropriate to the real factors (including transactors' time preferences or propensity to consume out of income) have been under-produced. In summary, the attempted extension of the production structure cannot be completed for lack of resources.

3.7.43

Monetary expansion began by lowering interest rates. Entrepreneurs, misled by the uncoordinated price signals, attempted to reduce all marginal rates of return to the same level. But in attempting to do so, they actually drove up ex post returns on some goods to levels higher than these interest rates.*104 Monetary expansion thus induces disproportionalities in the production of capital goods that are revealed in the depression: there is overproduction in some lines, underproduction in others. The focus on the disproportionalities that occur in a cyclical process and the emphasis placed on these discoordinating price signals are perhaps the distinguishing features of Austrian, or Hayekian, analysis. It is precisely these effects that are lost in modern aggregative macromodels.

3.7.44

From the foregoing analysis, it is clear that the aggregation of individual investment-demand curves into one aggregate-investment curve has no price-theoretic foundation. Demand for any capital good depends on its position in the production structure and the profitability of integrating it into different and varying capital combinations. Equally, changes in interest rates affect prices and supplies, not merely of produced goods used in further production, but also of land and labor services. In short, monetary expansion affects not merely "the" interest rate but alters an enormous complex of price-cost margins and resource allocations; "the interest rate" is merely an extremely clumsy and misleading shorthand phrase covering this vast and intricate web of interrelationships.

3.7.45

Monetary expansion thus sets in train an unsustainable change in the pattern of production, a change that must eventually be modified and reversed. Initially, as money incomes rise, the effects of the expansion may appear to be beneficial. But it is now that the unsustainable misallocations are being made, as prices of unfinished products rise relative to consumer goods prices. As the money permeates through the system, this relative price change is reversed, and consumer goods prices rise. The cluster of misallocations now stands revealed in the form of losses and unemployment, additional to those necessary for the continuous adaptation of production to changing circumstances. More specifically, resources become unemployed in stages farthest from consumption. This unemployment is reduced as consumer goods production picks up. Continuous monetary expansion can only perpetuate this cyclical discoordination in the capital structure and thus raise losses and unemployment above the level they would otherwise reach.

3.7.46

Such expansion cannot prevent real scarcities from manifesting themselves. Prices may be initially and temporarily influenced in a direction opposite to that of the underlying real factors. But it is not as if there were an infinite array of prices consistent with the real factors. Prices reflect not only monetary disturbances but also real influences—tastes, technology, and, above all, real scarcities.

3.7.47

Consequently, although monetary expansion has real misallocating effects, these "purely" monetary changes are self reversing.*105 Most contemporary economists would be chary of accepting this proposition. This reluctance stems, we feel, from the current approach, which assumes that output always has its equilibrium composition, and which treats money as determining only the nominal heights of prices that are always at their real equilibrium levels. If money has no real effect whatsoever, then there is none to reverse, and furthermore there are no misallocations to correct.*106

3.7.48

A final word: a monetary disturbance differs substantially from, for example, a tax-and-subsidy scheme. Taxes and subsidies do indeed reduce outputs of the taxed commodities while stimulating production of the subsidized ones. But there is no purely economic reason why taxes and subsidies, once imposed, need ever be removed. These disturbances merely lead to a new and stable allocation of resources, which persists as long as the taxes and subsidies continue. In the tax-cum-subsidy case, economic behavior is coordinated. There is no self-reversal.

PRICE EXPECTATIONS AND RESOURCE ALLOCATION

3.7.49

We have seen that monetary expansion systematically transmits misinformation throughout the economic system by moving prices in a direction opposite to that required by real structural factors. However, as expansion continues, price increases come to be expected.*107 Real scarcities and changed price expectations together serve to reduce somewhat those profit margins widened by purely monetary factors. If entrepreneurs find that ex post rates of return on certain goods (that is, consumer goods in general) are persistently higher than were expected ex ante, then they will come to anticipate this. Entrepreneurs will be willing to pay more to hire factors to produce those goods whose profit margins have proved to be greatest. Thus factor costs increase and profit margins decline for the producers of these capital goods appropriate to the lower rate of interest. Demand for these capital goods declines as entrepreneurs come to demand a different set of heterogeneous capital goods. Hence even with a constant rate of monetary expansion, we have the onset of the recessionary symptoms of a corrective reallocation. In these circumstances, if policymakers wish to raise apparent profit margins on firms producing inappropriate capital combinations to their previously inflated level, they must accelerate the monetary expansion. The ultimate limit to such a monetary policy is the abandonment of that money as a medium of exchange.

3.7.50

But even if monetary expansion proceeds at a constant rate, price expectations and real scarcities by no means obviate all the discoordinating effects of such a continuous disturbance; for it is not a matter of transactors' coming to anticipate the average increase in a set of prices—that is, the change in a price index. The impact on individual prices is still somewhat unpredictable, and hence profit margins on particular capital goods will continue to differ from expectations, because of purely monetary influences; some capital dislocation will thus continue.*108

THE INADEQUACIES OF A PURELY MONETARY APPROACH

3.7.51

We may now see the inadequacies of the Keynesian approach that argues that, when there is excess capacity and unemployed labor in both capital and consumption goods industries, credit expansion permits higher employment and output. If the excess capacity is idle because it has been malinvested and hence cannot be fitted into the capital structure, the increased credit can only add to these misallocations and thus create further potential future idleness for both capital and labor resources. As Hayek incisively noted:

It has of course never been denied that employment can be rapidly increased, and a position of 'full employment' achieved in the shortest possible time by means of monetary expansion—least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations. There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period.... But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space.*109

3.7.52

If many contemporary economists refer to recessions or depressions today, it is almost invariably to their purely monetary aspects. Thus Friedman argued that "the American economy is depression-proof": a drastic monetary decline on the lines of 1930-33 is now impossible because of deposit insurance and banking and fiscal changes.*110 Paul W. McCracken concurred that economic management "can probably avert a major and a generalized depression"—financial collapse on the 1930s scale has been so rare that it would be premature to anticipate something similar. (However, he sternly warned companies and financial institutions against the risks of unwise financing policies.)*111 Harry G. Johnson stated that it is a "virtual certainty that nations will never again allow a massive world recession to develop" since "their economists would know better than to accept disaster as inevitable or inexplicable."*112 Haberler entitled the foreword to the 1964 edition of his Prosperity and Depression "Why Depressions Are Extinct." He cited the strength of the United States financial structure, deposit insurance, refusal to tolerate a wholesale deflation, and the powerful built-in stabilizer of the government budget. By preventing a decline in expenditure, this policy has "proved to be a very powerful brake on deflationary spirals and has been a major factor in keeping depressions mild." Outlining the main features of business cycles, he stated:

A very significant fact is that the wholesale price level almost always rises during the upswing and falls during the downswing, and the money values—payrolls, aggregate profits etc.—always go with the cycle. This proves that changes in effective demand, rather than changes in supply, are the proximate cause of the cyclical movement in real output and employment.*113

3.7.53

None of these statements deal with the real misallocations resulting from monetary expansion or with the counteracting forces then set in motion. As we have seen, such counteracting forces, that is, recessionary symptoms, may appear to be (temporarily) fended off only if monetary expansion proceeds at an accelerating rate. If an expansion proceeds at a steady rate, recessionary symptoms appear nonetheless, and their onset is more rapid if the expansion decelerates.

STAGFLATION AND MONETARY ACCELERATION

3.7.54

In either case, it is the investment goods industries farthest from the production of consumer goods that feel the pinch first. If the monetary expansion continues steadily with the relative increase in consumer goods prices, firms nearer consumption bid away nonspecific resources from these industries, which now find that their costs rise faster than their selling prices. If the expansion slows down, there is an unambiguous decline in monetary demand for the investment projects begun at the lower interest rates. But even while unemployment and malinvested excess capacity appear in stages farthest from consumption, the incomes generated in the expansion are still working through the system. Consumer goods industries will maintain and even increase their demand for factor services: whereas at the beginning of the expansion these industries were outbid for factor services, they now face both an increase in demand and an increasing supply of nonspecific factors, as these are released by firms farther from consumption. Consumer prices may well continue to rise, but much depends on how rapidly output can be increased in these industries and nonspecific resources shifted back into consumer goods production. Mitigation of the level of employment also depends on both these elements.

3.7.55

From this analysis it is clear that attempts to maintain inflated capital values and incomes in the capital goods industries most affected would perpetuate the misallocation. Undoubtedly, there will be political pressure to do this:*114 the incomes of specific factors are most strongly affected by changes in demand for their services. But reflation—accelerated expansion—will lead to further maladjustments. Moreover, given the continuous steep rise in consumer prices, there will also undoubtedly be an opposing pressure from groups whose incomes lag behind. This pressure will often take the form of controls on prices (particularly those of consumer goods). Consumer price controls can only exacerbate the situation. By reducing returns in the consumer goods industries, they intensify the shortage of consumption goods.

3.7.56

As we have seen, it is the rise in consumption expenditures that precipitates the market pressure for resource reallocation. Attempts to stimulate consumption would intensify these reallocative pressures. A rise in voluntary saving, on the other hand, would help salvage some of the malinvestments. But these misallocations were created by the monetary expansion; as long as expansion continues, the capital structure will be dislocated, and malinvestments will arise, only some of which are salvageable.

3.7.57

To summarize: Under the impact of a monetary disturbance, prices will transmit misinformation. The revelation of this misinformation and its correction constitute a recession. The abnormal rise in losses and unemployment is the counterpart to the misallocations created by the misinformation. In short, monetary expansion and recession are inseparable!

3.7.58

If the expansion is halted, the recession is precipitated rapidly. It may be extensive and deep. But once the readjustment is completed and a sustainable pattern of output and employment established, there need be no further allocative difficulties and certainly no currency depreciation.

3.7.59

If monetary expansion continues, recessionary symptoms of greater and greater intensity appear. But the readjustment will not be wholly completed. The pattern of output and employment is continuously dislocated. Eventually, losses and unemployment persist in rising and continue at ever higher levels despite the continuing expansion.*115

3.7.60

If the expansion is repeatedly accelerated to overcome the recession, the outcome is obvious. Such a situation may well come to face the developed economies of the Western world, unintentionally, no doubt as the consequence of the cumulative outcome of successive decisions to expand the money supply in the face of the threatening depression. The economists quoted here assure us that our financial system will never permit another Great Depression. Can they also assure us that it will never permit a hyperinflation?

3.7.61

Samuelson seemed to think not. He pointed out that monetary expansion occurs in response to "populist" pressures to "avoid policies that would worsen short-run unemployment and stagnation problems." He therefore saw the outlook as one of "creeping or trotting inflation. The problem is how to keep the creep or trot from accelerating. This includes the challenge of finding new macroeconomic policies beyond conventional fiscal and monetary policies that will enable a happier compromise between the evils of unemployment and of price inflation." But he stressed that "a Draconian policy of insisting upon stable prices at whatever cost to current unemployment and short-run growth" would be a "costly investment in fighting inflation," since he saw no guarantee "that even in the longest run the benefits to be derived from militant anti-inflationary policies don't carry excessive costs as far as average levels of unemployment and growth are concerned." He went on to warn that "mankind at this stage of the game can ill afford to make irreversible academic experiments whose outcomes are necessarily doubtful" and whose implementation would exacerbate political tensions. He was confident such an anti-inflation policy "will assuredly never be followed."*116

3.7.62

Truly, inflation does leave us holding a "tiger by the tail," as Hayek remarked:

Now we have an inflation-borne prosperity which depends for its continuation on continued inflation. If prices rise less than expected, then a depressing effect is exerted on the economy....to slow down inflation produces a recession. We now have a tiger by the tail: how long can this inflation continue? If the tiger (or inflation) is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished! I'm glad I won't be here to see the final outcome.*117

See, for example, United Nations, Economic Commission for Europe, Economic Survey of Europe in 1961: Some Factors in Economic Growth in Europe during the 1950's (E/ECE/452/Add. 1) (Geneva 1954), pp. 23-32; Great Britain, Council on Prices, Productivity, and Incomes, Fourth Report (HMSO 1961); Great Britain, National Economic Development Council, Conditions Favourable to Faster Growth (HMSO April 1963); Great Britain, National Economic Development Council, Growth in the U.K. Economy to 1966 (HMSO February 1963); Political and Economic Planning, Growth in the British Economy (London: Allen & Unwin, 1960), pp. 1-53, 197-219; Angus Maddison, Economic Growth in the West: Comparative Experience in Europe and North America (London: Allen & Unwin, 1964).

See tables referred to in note 2; also see Organization for Economic Cooperation and Development, OECD Economic Outlook 15(July 1974):73-77; and almost any issue of The Economist, e.g., "To Meet Slumpflation" and "Mass Unemployment Ahead?" The Economist 250(23 March 1974):14-16; "Before Taking to Wheelbarrows," The Economist 252(20 July 1974):65-66; see also the report from Peter Jay, "OECD forecasts increased inflation in Britain for first half of next year; Reflation 'would make matters worse,'" Times (London), 3 October 1974, p. 1; and National Institute of Economic and Social Research, National Institute Economic Review 69(August 1974):4-26.

For an indirect demonstration that the existence of money makes sense only in a multicommodity world and that a multicommodity world is virtually inconceivable in the absence of a medium of exchange, see Carl Menger, Principles of Economics (Glencoe, Ill.: Free Press, 1950), pp. 236-85. It should be pointed out that in the more sophisticated versions of the Keynesian analysis, changes in interest rates do affect the prices of investment goods relative to the prices of consumer goods. See the extensive discussions of aggregation in Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (New York: Oxford University Press, 1969), pp.20-23, 111-85.

"The aspect of Keynes' theory which has created the most trouble...is his theory of interest—which is rather a theory of short-run interest movements" (Leijonhufvud, Keynesian Economics, pp. 12-13). We maintain that modern Keynesian writers have still not solved this problem.

See Charles W. Baird, Macroeconomics (Chicago: Science Research Associates, 1973), for an example of a recent attempt to introduce price-level flexibility and to adopt a micro approach in macroanalysis. Attempts like this, though praiseworthy, have not been successful. Microanalysis deals with pricing and resource allocation and hence with the time structure of output and prices. Microeconomics is far more than the analysis of single prices in isolation. Manipulation of price levels would seem to have little to do with microanalysis in this sense.

The following analysis and interpretation of the monetarist position is based on Milton Friedman, "A Theoretical Framework for Monetary Analysis," Journal of Political Economy 78(March-April 1970):193-238; idem, "A Monetary Theory of Nominal Income," Journal of Political Economy 79(March-April 1971): 323-37; idem, Dollars and Deficits (Englewood Cliffs, N. J.; Prentice-Hall, 1969).

Friedman admitted that he and Anna J. Schwartz "have little confidence in [their] knowledge of the transmission mechanism, except in such broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint" (The Optimum Quantity of Money [Chicago: Aldine Publishing Co., 1969], p. 222).

Hayek first presented his monetary analysis of the business cycle to the English-speaking world in four lectures at London University in 1931; see Friedrich A. Hayek, Prices and Production (London: Routledge & Kegan Paul, 1935). His earlier German work on monetary theory was translated and published in 1933; idem, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966). In 1939 Hayek developed his theory further in an essay entitled "Profits, Interest, and Investment," which he published along with some of his earlier articles under the same title; see idem, Profits Interest and Investment (New York: Augustus M. Kelley, 1970); see also idem, "Three Elucidations of the Ricardo Effect," Journal of Political Economy 77 (March-April 1969):274-85.

Two types of complementarity exist: "horizontal complementarity," where goods in any one stage of production must be integrated, and "vertical complementarity," where goods must be integrated between stages.

Hayek referred to this effect as the "Ricardo effect." For references to Hayek's writings and further explanations, see Gerald P. O'Driscoll, Jr., "The Specialization Gap and the Ricardo Effect: Comment on Ferguson," History of Political Economy 7(Summer 1975): 261-69.

The view that the effects of monetary expansion are self-reversing meets with hostility; see, for example, Friedman, "Comments on the Critics," Journal of Political Economy 80(September-October 1972): 936-41. It is ironic that, in his 1974 address to the Southern Economics Association in Atlanta, Friedman acknowledged that less unemployment now (caused by an unanticipated increase in the growth rate of the money supply) will result in more unemployment later; that is, cyclical expansions bring about cyclical contractions. While it is true that Friedman's talk made no reference to real factors of the type discussed here, still it is an improvement over his earlier attitude where he refused to consider this form of reasoning at all.

Even with "indexation," however widespread, new money would still enter the economy at a specific point and first alter some relative prices and outputs before altering other prices and outputs. These misallocations and subsequent corrections would continue as long as the increase in the money supply persisted. Indexation of money payments would merely add yet another unpredictable relative price change to those already set in motion by the monetary disturbances. In particular, some incomes would continue to rise ahead of the consumer price index while others would rise after it. Indexation would only allow for (known) past changes in the consumer price index resulting from those increases in the money supply that had already worked through the economy. It could do little ex ante about present increases in the money supply still working their way through the economy. The case for indexation is made by a number of economists; see especially Milton Friedman, Monetary Correction (London: Institute of Economic Affairs, 1974).

The general council of the U.K. Trades Union Congress demanded government subsidies for all firms threated with losses and therefore having to lay off workers; see the report by John Elliott, "TUC urges more government control over redundancies," Financial Times (London), 24 October 1974, p. 1.

Thus aggregate money expenditure rose by 248 percent in the United Kingdom between 1949 and 1969, but output rose only 69 percent. Similar money increases may be adduced for other developed countries. Nevertheless, Denis Healey, chancellor of the exchequer, found it necessary to issue a warning to the 1974 Conference of the International Monetary Fund not to repeat "the tragedy of the 1930's [by attempting] to deal with inflation by measures likely to produce mass unemployment"; see the report entitled "Mr. Healey warns the world on threat of 1930's tragedy being repeated," and the report from Peter Jay, "Chancellor emphasizes need to avoid mass unemployment," The Times (London), 2 October 1974, p. 1.

From Hayek's remarks at the Mont Pelerin Conference, Caracas, September 1969; these remarks are on record only in Friedrich A. Hayek, A Tiger by The Tail, ed. Sudha R. Shenoy, Institute of Economic Affairs, Hobart Paper no. 4 (London, 1972), p. 112.

Part 4, Essay 1, Austrian Economics in the Age of the Neo-Ricardian Counterrevolution

End of Notes

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